Tax Changes for Individuals in the ‘Fiscal Cliff’ Law
After months of arguing about the “fiscal cliff,” Congress finally passed a law averting some of the tax increases that were set to take effect on January 1, 2013. The American Taxpayer Relief Act of 2012, also known as the “fiscal cliff legislation,” was signed into law by President Barack Obama on January 2, 2013.
After months of arguing about the “fiscal cliff,” Congress finally passed a law averting some of the tax increases that were set to take effect on January 1, 2013.
The American Taxpayer Relief Act of 2012, also known as the “fiscal cliff legislation,” was signed into law by President Barack Obama on January 2, 2013. Despite the name of the law, all workers will pay higher federal taxes this year due to the demise of the so-called “payroll tax holiday.”
The good news: The new law cancels income tax increases that would have added misery. It also makes several provisions permanent, which will result in less uncertainty (see list of nine items below).
The bad news: Higher-income folks will face higher tax rates, starting this year. And there are a couple other new taxes kicking in this year (not part of the new law), which may take you by surprise.
This article summarizes the most important changes for individual taxpayers.
The Payroll Tax Holiday Is Over
For 2011 and 2012, the Social Security tax withholding rate on an employee’s salary was temporarily reduced from the normal 6.2 to 4.2 percent. If you’re self-employed, the Social Security tax component of the self-employment tax was reduced from the normal 12.4 to 10.4 percent. Last year, this payroll tax holiday could have saved one person up to $2,202 (up to $4,404 for a married couple with two incomes). Unfortunately for working folks, the new law does not extend the payroll tax cut through 2013.
Key Point: For this year, the Social Security tax can hit up to $113,700 of salary at a 6.2 percent rate and up to $113,700 of self-employment income at a 12.4 percent rate.
Tax Increases for Higher-Income Individuals
Rates on Ordinary Income: For most individuals, the federal income tax rates for 2013 will be the same as they were for 2012: 10, 15, 25, 28, 33, and 35 percent. However, the maximum rate for higher-income folks increases to 39.6 percent (up from 35 percent). This change only affects:
|Married joint filer||$450,000|
|Head of household||$425,000|
|Married filing separately||$225,000|
Rates on Long-Term Gains and Dividends: The tax rates on long-term capital gains and dividends will also remain the same as last year for most individuals. However, the maximum rate for higher-income folks increases to 20 percent (up from 15 percent). This change only affects singles with taxable income above $400,000, married joint-filing couples with income above $450,000, heads of households with income above $425,000, and married individuals who file separate returns with income above $225,000. These changes are permanent (until further notice).
Important: These higher-income folks can also get hit with the new 3.8 percent Medicare surtax on investment income, which can result in a maximum 23.8 percent federal tax rate on 2013 long-term gains and dividends.
The 3.8 percent Medicare surtax on net investment income and a new 0.9 percent Medicare tax on wages and self-employment income both affect higher income taxpayers and became effective on January 1, 2013. They were not part of the new fiscal cliff law.
Phase-Out Rules Are Back
Before 2010, higher-income taxpayers had their itemized deductions and personal exemption write-offs “phased out.” This means that they didn’t get the full benefit of the most popular tax breaks.
The phase-out rules were deactivated for 2010 through 2012. Regrettably, the new law brings them back on a permanent basis.
Personal and Dependent Exemption Deductions: Your personal and dependent exemption write-offs can be reduced or even eliminated.
Itemized Deductions: You can potentially lose up to 80 percent of your write-offs for mortgage interest, state and local income and property taxes, and charitable contributions if your adjusted gross income (AGI) exceeds the applicable threshold.
Specifically, the total amount of your affected itemized deductions is reduced by 3 percent of the amount by which your AGI exceeds the threshold. However, the reduction cannot exceed 80 percent of the total affected deductions you started off with.
For both personal/ dependent exemptions and itemized deductions, the AGI thresholds are $250,000 for singles, $300,000 for married joint-filing couples, $275,000 for heads of households, and $150,000 for married individuals filing separately.
Several Tax Breaks Made Permanent
One of the most confusing and frustrating aspects of the tax code is lawmakers’ practice of making tax breaks available for a year or two — and then deciding whether or not to extend them. Thankfully, the new law makes several provisions “permanent.” This doesn’t mean that Congress will neverdiscontinue these tax breaks but we now have some certainty that the following will stick around for awhile:
1. Relatively Favorable Gift and Estate Tax Rules – For 2013 and beyond, the new law permanently installs a unified federal estate and gift tax exemption of $5 million — adjusted annually for inflation — and a 40 percent maximum tax rate (up from last year’s 35 percent rate). For 2012, the exemption amount was $5.12 million after being adjusted for inflation. For 2013, the inflation-adjusted exemption amount is expected to increase. The new law also makes permanent the right to leave your unused federal estate and gift tax exemption to your surviving spouse (the so-called “exemption portability” feature).
2. Alternative Minimum Tax Patch – It had become an annual ritual for Congress to “patch” the AMT rules to prevent millions more households from getting hit with this add-on tax. The patch consisted of allowing larger inflation-indexed AMT exemption amounts and allowing various personal tax credits to offset the AMT. Thankfully, the new law makes the patch permanent, starting with 2012. As a result, about 30 million households a year will be kept out of the AMT zone.
The new law increases AMT exemption amounts for 2012 to $50,600 for single taxpayers; $78,750 for married joint filers; and $39,375 for married taxpayers filing separately. (For 2013, these amounts are projected to be $51,900, $80,750 and $40,375, respectively.)
3. Marriage Penalty Relief – Getting married can cause a couple’s combined federal income tax bill to be higher than when they were single. The Bush tax cut legislation eased the so-called marriage penalty by tweaking the lowest two tax brackets for married couples and by giving them bigger standard deductions. These fixes were scheduled to disappear after 2012, but the new law makes them permanent.
4. Larger Child Tax Credit – The $1,000 maximum credit for each eligible under-age-17 child was made permanent. Without the new law, the maximum credit would have dropped to only $500 for 2013 and beyond. In addition, provisions that allow the child credit to be refundable for more households were extended through 2017.
5. Favorable Child and Dependent Care Tax Credit Rules – Under the Bush tax cut legislation, most working parents have been able to claim a credit of up to $600 for costs to care for one under-age-13 child, or up to $1,200 for costs to care for two or more under-age-13 kids. Lower-income parents have been able to claim larger credits of up to $1,050 and $2,100, respectively. The new law makes these credit amounts permanent for 2013 and beyond (without the new law, they would have dropped to $480 and $960 for most parents; $720 and $1,440 for lower-income parents).
6. Favorable Student Loan Interest Deduction Rules – This write-off, which can be as much as $2,500 (whether you itemize or not) was scheduled to fall under less-favorable rules in 2013 and beyond. There would have been a 60-month limit on deductible interest, and a stricter phase-out provision would have reduced or eliminated the deduction for many middle-income taxpayers. The new law permanently extends the favorable rules that have applied in recent years.
7. Favorable Coverdell Education Savings Account Rules – For 2013 and beyond, the maximum annual contribution to these federal-income-tax-free college savings accounts was scheduled to drop from $2,000 to a paltry $500, and a stricter contribution phase-out rule would have applied. The new law makes permanent the favorable rules that have applied in recent years.
8. Employer Education Assistance Plans – In recent years, employers could provide up to $5,250 in annual federal-income-tax-free educational assistance payments to an eligible employee. Both undergraduate and graduate school costs were eligible and the education did not need to be job-related. This was scheduled to expire at the end of 2012, but the new law makes it permanent.
9. Tax Breaks for Adoptive Parents –The Bush tax cut package included a major liberalization of the adoption tax credit and also established tax-free employer adoption assistance payments. These taxpayer-friendly provisions were scheduled to expire at the end of 2012. The credit for up to $10,000 of expenses (indexed for inflation) would have been halved and limited to special needs children only. Tax-free adoption assistance payments from employers would have disappeared. The new law permanently extends the favorable rules.
Higher Education Tuition Deduction
This tuition write-off, which can be $4,000 or $2,000 depending on income, expired at the end of 2011. The new law retroactively restores it for 2012 and extends it through 2013. (You cannot claim this deduction and the American Opportunity credit for the same student in the same tax year.)
Option to Deduct State and Local Sales Taxes
In past years, individuals who paid little or no state income taxes were given the option of instead claiming an itemized deduction for state and local sales taxes. The option expired at the end of 2011, but the new law restoratively restores it for 2012 and extends it through 2013.
Earned Income Tax Credit
Legislation enacted in previous years increased the earned income credit for families with three or more qualifying children and allowed married joint-filing couples to earn more without having their credits reduced. These changes, which help lower-income families, were extended through 2017.
American Opportunity Higher Education Credit
The American Opportunity credit, which can be worth up to $2,500 and can be claimed for up to four years of undergraduate education, was extended through 2017. The full credit is available to single individuals whose modified adjusted gross income (MAGI) is $80,000 or less ($160,000 for married couples filing jointly).
Charitable Donations from IRAs
In past years, IRA owners who had reached age 70½, were allowed to make tax-free charitable donations of up to $100,000 directly out of their IRAs. The donations counted as IRA required minimum distributions. Charitably inclined seniors could reduce their income taxes by arranging for tax-free IRA donations to take the place of taxable required distributions.
This break expired at the end of 2011, but the new law retroactively restores it for 2012 and extends it through 2013. To take advantage of the retroactive deal, you can treat donations made in January of this year as having been made in 2012. You can also donate IRA distributions taken in December of last year to charities and treat them as 2012 IRA donations. You must transfer such amounts to qualified charities by January 31, 2013.
Parity for Employer-Provided Parking and Transit Benefits
For 2012, employer-provided parking allowances are tax-free up to a monthly limit of $240. For 2013, the monthly limit is $245. Thanks to the new law, you can be given up to these same amounts last year and this year for tax-free transit passes or vanpooling. For example, you could get up to $245 per month this year to pay for the park and ride plus up to another $245 to pay for the train.
Without the new law, there would have been only a $125 monthly limit on employer-provided transit passes and vanpooling for 2012 and 2013. (If your company doesn’t pay for these fringes, it might offer a salary reduction arrangement instead.)
Tax-Free Treatment for Forgiven Principal Residence Mortgage Debt
For federal income tax purposes, a forgiven debt generally counts as taxable cancellation of debt (COD) income. However a temporary exception applied to COD income from cancelled mortgage debt that was used to acquire a principal residence. Under the temporary rule, up to $2 million of COD income from principal residence acquisition debt that was cancelled in 2007-2012 was treated as a tax-free item. The new law extends this break to cover eligible debt cancellations that occur in 2013.
Deduction for K-12 Educators’ Expenses
The $250 deduction for teachers and other K-12 educators for school-related expenses paid out of their own pockets was retroactively restored for 2012 and extended through 2013.
Energy-Efficient Home Improvement Credit
In past years, taxpayers could claim a tax credit of up to $500 for certain energy-saving improvements to a principal residence. This break expired at the end of 2011, but the new law retroactively restores it for 2012 and extends it through 2013.
Mortgage Insurance Premium Write-off
Premiums for qualified mortgage insurance on debt to acquire, construct, or improve a first or second residence can potentially be treated as deductible qualified residence interest. Before the new law, this break was only available for premiums paid through 2011. The new law retroactively restores the break for premiums paid in 2012 and extends it to cover premiums paid in 2013. However, the deduction is only available for premiums for qualifying policies issued after December 31, 2006 and premium amounts allocable to periods before 2014 and it is phased out for higher-income taxpayers.
Qualified Conservation Contributions
Liberalized deduction rules for qualified conservation contributions expired at the end of 2011. The new law retroactively restores them for tax years beginning in 2012 and extends them through tax years beginning in 2013. Qualified conservation contributions are charitable donations of real property interests, including remainder interests and easements that restrict the use of real property.
For individuals, the maximum write-off for qualified conservation contributions of long-term capital gain property is increased from the normal 30 percent to 50 percent of adjusted gross income. In addition, qualified conservation contributions are not counted when calculating an individual’s allowable write-offs for other charitable contributions. Qualified conservation contributions in excess of what can be written off in the year of the donation can be carried forward for 15 years (only a five-year carryover period is allowed under the normal rules). For an individual who is a qualified farmer or rancher, the qualified conservation contribution write-off for donated farm or ranch real property can be as much as 100 percent of the donor’s AGI. However, the donation must include a usage restriction stating that the property must remain available for agricultural or livestock production.
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– content reprinted with permission from BKR International.
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